Cathay Haitong: Wosh Receives Nomination—Changes to the Federal Reserve’s Independence and the U.S. Treasury Strategy Response

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Guotai Haitong Securities Research

Report Overview: The changing policy stance of the Fed, the unchanged dilemma of Federal Reserve independence. U.S. debt strategies prioritize defense, maintain neutral duration, and control volatility.

1. Focus on the Fed’s leadership change: Outlook on monetary policy and the U.S. bond market

1.1 Review of historical patterns before and after Fed leadership transitions: changes in monetary policy and bond market trends

From historical experience, Fed chair changes mainly impact the bond market through increased yield volatility, adjustments in the yield curve shape, and risk premium revaluation. The 6-12 months before and after a leadership change are typically periods of high policy uncertainty, as markets doubt the new chair’s policy stance, communication style, and independence. This uncertainty directly leads to increased bond market volatility and wider liquidity premiums.

Looking at yield trends, bond market performance during leadership transitions shows clear “scenario dependence.” In 2006, during Greenspan-Bernanke handover, the 10-year U.S. Treasury yield fluctuated within only 30 basis points around the transition, indicating policy continuity; in 2014, during Bernanke-Yellen transition at the start of QE unwind, the 10-year yield rose from 2.7% before the transition to 3.0% by year-end, reflecting market re-pricing of normalization; in 2018, during Yellen-Powell transition amid strong economy and rising inflation, the 10-year yield quickly climbed from 2.4% to 3.2%, with the flattening trend accelerating, and markets worried about a gradual rate hike continuation leading to an inverted curve.

Regarding curve shape, leadership changes often trigger structural shifts in the term spread. Historical data shows that if the new chair is perceived as “dovish,” short-term rates tend to be suppressed by rate cut expectations, steepening the curve; if viewed as “hawkish,” the long end rises faster due to inflation concerns, causing the curve to steepen then flatten. In 2018, Powell continued rate hikes, narrowing the 2s10s spread from 50 basis points to under 20, eventually leading to inversion in 2019 and prompting the Fed to cut rates. This “leadership change—policy expectation—curve adjustment—policy correction” feedback loop is common historically.

On risk premiums, the MOVE index (U.S. Treasury volatility index) increased on average by 15-25% during leadership transitions, reflecting heightened market divergence over policy paths. If the new chair is from within the Fed or continues previous policies, premium increases are moderate; if an external candidate with political overtones, concerns over independence push up term and liquidity premiums significantly. In 2018, despite being an outsider, Powell’s policy continuity kept MOVE only briefly elevated; in contrast, Volcker’s aggressive shift after 1979 kept bond volatility high for two years.

The 2026 leadership change environment will be more complex: sticky inflation, pause in rate cuts, geopolitical risks, and tariff policies intertwine, compounded by ongoing pressure from Trump on Fed independence, making market expectations for the new chair’s stance highly sensitive.

1.2 About Kevin Warsh: Career background and policy stance

Kevin Warsh, aged 55, is a typical “Wall Street–White House–Fed” elite. His career began at Morgan Stanley’s M&A department, where he served as Vice President and Executive Director from 1995-2002. In 2002, he joined the Bush administration, serving as Executive Secretary of the White House National Economic Council and Special Assistant to the President for Economic Policy, overseeing domestic financial, banking, and securities regulation policies, and acting as liaison with independent financial regulators. In February 2006, Bush nominated him as Fed Governor at age 35, making him the youngest in history, serving until March 2011. During his tenure, he represented the Fed at G20, served as Asia economic envoy, and was an Administrative Director (responsible for personnel and finance). During the financial crisis, he was part of Bernanke’s inner circle, acting as an intermediary between the central bank and Wall Street CEOs. After leaving the Fed, Warsh was a visiting scholar at Stanford Graduate School of Business, a distinguished visiting scholar at the Hoover Institution, and authored a monetary policy reform report for the Bank of England, which was adopted by the UK Parliament.

On policy stance, Warsh is a staunch “hawk on balance sheet” and “tough on inflation.” In recent interviews, he explicitly stated “inflation is a policy choice, not an exogenous shock,” directly blaming the Fed (not supply chains or geopolitical conflicts) for the high inflation of 2021-2023. His core critique centers on “complacency”: he believes the Fed misjudged the death of inflation during the “great easing” period, failing to exit stimulus policies during 2010-2020, which led to the crisis (pandemic) forcing it to breach red lines and sow inflation seeds. Warsh argues the Fed has deviated from its core mission of price stability, experiencing “institutional drift,” and calls for “revival rather than revolution” reforms.

In monetary policy operations, Warsh has advocated aggressive balance sheet reduction (QT) to create room for rate cuts—“less printing money, lower interest rates.” This strategy is seen as a compromise to Trump’s calls for rate cuts—allowing short-term easing but using balance sheet runoff to prevent inflation rebound. Warsh has long opposed QE normalization; in 2009, with unemployment at 9.5%, he argued the Fed should start tapering, warning excess reserves could trigger credit surges. During the QE2 debate in 2010, he expressed “substantive reservations,” believing monetary policy had reached its limit and additional bond purchases risked inflation and financial stability. Market analysts believe that if Warsh leads the Fed, it would push for faster rate hikes, MBS sales, and significantly raise the threshold for future QE, lowering bond term premiums. His core policy idea is “Fed and Treasury roles separate”: the central bank controls interest rates, the Treasury manages fiscal accounts, and a “new agreement” addresses debt service costs, avoiding blurred responsibilities.

1.3 Recent shift in Warsh’s monetary stance: from hawkish inflation to “pragmatic monetarism”

Recently, Warsh’s policy stance has shifted notably from traditional hawkish inflation to support rate cuts, sparking intense market debate about his true position. Investors expect that his nomination would steepen the yield curve, reflecting concerns over his hawkish past, but some see this as “signal rather than conviction”—a pre-nomination stance adjustment to align with presidential preferences, which is more strategic than post-nomination pressure, “those who read the times are wise.”

Theoretical support for his stance shift hinges on two points. First, AI-driven anti-inflation narrative. In a November 2025 WSJ column, Warsh emphasized AI as a “powerful anti-inflation force” that will boost productivity and US competitiveness, advocating the Fed “abandon forecasts of stagflation in the coming years.” He criticizes the “wage-price spiral” doctrine, attributing inflation to “government overspending and excessive money printing,” not labor market overheating. Second, the “balance sheet reduction combined with rate cuts” policy mix. In July 2025, Warsh stated that large-scale balance sheet runoff could “inject turbocharge into the real economy,” achieving structural rate cuts, noting “we are in a housing recession, with 30-year fixed mortgage rates near 7%.”

However, market doubts the sustainability of his shift. Analyses generally suggest Warsh’s “hawkish monetarist” stance could lead to more cautious policy pacing. Notably, during his 2006-2011 tenure, even at the depths of the financial crisis, he called for rate hikes—this anti-inflation instinct contrasts sharply with his current support for rate cuts. If inflation does not fall as expected in 2026 or AI productivity effects fall short, the probability of Warsh returning to hawkishness will rise significantly.

1.4 Considering Trump’s “speciality”: the independence dilemma of Fed chair nominations

Trump’s influence on the Fed has shifted from “Twitter pressure” in his first term to “systemic restructuring” in his second. Currently, three of the seven Fed governors are his nominations: Michelle Bowman and Christopher Waller, appointed during his first term, and Stephen Miran, who took office in August 2025. But their independence varies markedly: Bowman and Waller, at the September 2025 meeting, refused to follow Miran’s aggressive 50 basis point rate cut proposal and voted with Powell, which Harvard economist Jason Furman called a “positive sign of Fed independence.” In contrast, Miran’s stance aligns closely with the White House; a report co-authored by him in 2024 with others from the Manhattan Institute explicitly states “Fed independence is outdated,” and suggests the president should have the power to dismiss Fed officials at will.

This divergence reflects Trump’s evolving nomination strategy: initial nominations respected professional background and academic independence—Bowman and Waller, though seen as “doves,” maintained technocratic independence; the second term shifted toward “political loyalty,” with Miran’s background as an economic advisor and his support for tariffs and tax cuts, indicating a shift from “policy preference” to “political allegiance.” Trump has also attempted to threaten Powell’s removal through Justice Department investigations and accused Biden’s nominee Lisa Cook of mortgage fraud (which she denies)—a first in Fed history.

However, Warsh’s potential nomination seems inconsistent with Trump’s aim to strengthen influence over the Fed. Unlike Miran’s “presidential mouthpiece,” Warsh is an “anti-establishment hawk”—opposing excessive Fed easing and mission drift, not obedient to presidential rate-cut orders. This creates an internal contradiction for Trump: he wants “fast, multiple rate cuts” to stimulate growth and ease debt burdens, but Warsh advocates “slow rate cuts and quick balance sheet runoff” to curb inflation. Historically, strong chairs can override the majority of the board—Greenspan and Volcker, during their tenures, often cast dissenting votes and led policy directions. If Warsh takes office, his “zero tolerance for inflation” stance will likely attract Bowman and Waller back to hawkish camp, marginalizing dovish Miran, shifting FOMC voting from “dove-hawk balance” to “hawk-dominated.”

We believe Trump’s selection process may relate to three factors:

1) Warsh’s shift toward supporting rate cuts. Since late 2025, Warsh has gradually moved to support rate cuts in various public statements, emphasizing that AI-driven productivity gains will alleviate supply constraints, creating room for more accommodative policy. This evolution contrasts sharply with his previous hawkish inflation stance, reflecting a pragmatic policy adjustment.

2) Enhancing policy credibility and market confidence. Compared to purely dovish rhetoric, Warsh’s support for rate cuts based on technological progress is more convincing in maintaining market trust and aligns with Trump and Treasury Secretary Yellen’s goals. This approach fits the administration’s economic growth agenda while avoiding excessive easing that could spark inflation concerns.

3) Providing policy risk buffers. From a political economy perspective, the Fed remains an important policy responsibility dispersal mechanism for Trump. Warsh’s cautious monetary stance preserves professionalism while allowing flexibility to support White House economic policies. This “principled yet adaptable” balance can sustain market confidence in central bank independence and provide room for policy explanations if economic outcomes fall short, sharing risks between administration and monetary policy.

1.5 Forward-looking policy direction of the “Warsh era” at the Fed

Looking ahead, under Warsh’s leadership, the Fed may exhibit three main features:

1) The independence paradox intensifies policy uncertainty. Whether Trump can tolerate a “disobedient hawk” remains uncertain. Historical experience shows that Fed chairs tend to gradually demonstrate independence based on reputation and institutional interests. The 2018 public conflict between Powell and Trump is a warning—despite Powell’s nomination by Trump, his rate hike path eventually angered the White House. If Warsh faces White House pressure to cut rates again, his firm resistance could lead to a replay of the Nixon-Bernstein conflicts of the 1970s, with bond markets facing “policy credibility discount” and “political intervention premiums.”

2) Gradual convergence of rate cut paths and the “dove-first, hawk-later” risk. Warsh’s latest statements emphasize the need for “flexible adjustment” in interest rate policy, without explicit commitments to continuous rate cuts. Coupled with signals from the January meeting to hold rates steady and his longstanding inflation vigilance, the pace of rate cuts in 2026-2027 is likely to slow significantly, with actual cuts well below market expectations. Notably, Warsh may follow a “dove first, hawk later” trajectory—initially stabilizing expectations and consolidating his position, then gradually shifting to tightening if inflation rebounds, with thresholds lower than market anticipations.

3) Aggressive balance sheet runoff weakening bond market support. Accelerated MBS sales and maturing bonds not reinvested will reduce the Fed’s “hidden buyer” role, increasing term and liquidity premiums.

2. FOMC decision: pause rate cuts, monitor inflation and economic data

2.1 Behind the Fed’s pause: policy balance shifts back to “fighting inflation”

On January 28, the FOMC decided to keep the federal funds rate target at 3.5%-3.75%, in line with expectations, marking the pause of the rate-cutting cycle that began in September 2025. The decision was approved by 10 votes, but notably, Miran and Waller voted against, favoring a 25 basis point cut, indicating internal policy disagreements.

The wording of the statement shows a clear tilt toward fighting inflation. It states that economic activity is expanding at a solid pace, with an upward revision of growth assessment from December; labor market language shifted from “slowing employment growth” to “employment growth remains low, with signs of stabilization in the unemployment rate,” removing the previous “labor market risks outweigh inflation risks” phrase, suggesting a more balanced view of dual mandates. Inflation remains “somewhat elevated,” implying the process of convergence toward 2% has stalled.

Forward guidance remains cautious, removing explicit references to rate cuts. This aligns with the signals from December’s meeting of a slower pace of easing, and markets interpret it as a wait-and-see stance through at least the first half of the year. The statement emphasizes high uncertainty about the economic outlook, a diplomatic way of acknowledging the unpredictable impact of tariffs, leaving ample flexibility for future policy adjustments.

On technical operations, the Fed maintained the interest rate on reserve balances (IORB) at 3.65%, the overnight reverse repurchase rate (ON RRP) at 3.5%, and continued reinvesting only maturing principal into short-term Treasuries, indicating the balance sheet runoff has not halted despite the pause in rate cuts. Overall, the key message is: amid persistent inflation and resilient economy, the Fed is “holding steady,” waiting for more data to confirm the inflation downtrend, with a likely reassessment of rate cuts not before Q2.

2.2 Economic and inflation outlook: resilience amid sticky inflation

The Fed’s assessment of the economic fundamentals has improved significantly since December, supporting the decision to hold rates steady. In the real economy, the BEA’s revised Q3 2025 GDP growth rate reached an annualized 4.4%, up 0.1 percentage points from initial estimates, the strongest since Q3 2023. Quarter-over-quarter, real GDP accelerated from 3.8% in Q2 to 4.4% in Q3, driven mainly by consumer spending (contributing 2.34 percentage points), export rebound (1.00), and government spending recovery. Notably, real final sales (excluding inventory changes) grew at 4.5%, indicating strong endogenous momentum rather than inventory buildup.

The labor market shows a delicate balance of stabilization without overheating. The BLS reported only 50k new nonfarm jobs in December 2025, with a total increase of 584k for the year—much lower than 2 million in 2024. The unemployment rate held at 4.4%, slightly up from 4.1% in December 2024, but long-term unemployed increased by 397k to 1.9 million, with long-term unemployment rate rising to 26.0%. Labor force participation and employment-population ratio remained stable at 62.4% and 59.7%. Wage growth remains resilient, with private sector average hourly earnings up 3.8% year-over-year, and monthly growth of 0.3% to $37.02, supporting consumption without triggering wage-price spirals.

Inflation remains the key policy challenge. BEA data show Q3 PCE price index and core PCE rose 2.8% and 2.9%, both above the Fed’s 2% target. CPI in December increased 2.7% year-over-year, remaining in the 2.7%-2.9% range for several months, indicating persistent core inflation. The statement removed the phrase “progress toward 2% inflation,” replacing it with “inflation remains somewhat elevated,” implying the downtrend has stalled. Tariff policies are a major uncertainty; tariff announcements by the Trump administration pushed CPI higher for several months in H2 2025, though the increase was below market expectations.

Overall, the Fed faces a dilemma of “growth resilience and inflation stickiness,” with economic data supporting a pause in rate cuts but leaving room for data-dependent future adjustments.

3. U.S. bond strategy recommendations: symmetric pricing, dual-directional defense

Amid Warsh’s nomination and increased uncertainty about the rate cut path, asset allocation should focus on “symmetric pricing and dual-directional defense,” rather than betting solely on “end of rate cuts” or “rapid easing.” In terms of duration, it is recommended to keep the portfolio duration slightly above neutral:

1. With rates already significantly lowered but risks of rising inflation and policy tightening still present, overly extending duration offers limited value; a moderate extension to 3–5 years can capture coupon income and capital gains under “mild rate cuts.”

2. Curve strategy could adopt a “mid-curve bias, moderate defense at the long end,” balancing potential steepening and flattening risks.

3. On credit and spreads, under a neutral risk appetite, consider modestly increasing credit risk exposure, favoring high-grade bonds with solid fundamentals, visible cash flows, and moderate leverage, while avoiding low-rated assets highly sensitive to rates and economic cycles. In phases of increased uncertainty, duration contribution should take precedence over credit beta, with overall duration kept within 3–5 years to avoid excessive interest rate risk.

4. Additionally, consider allocating some proportion to floating-rate and inflation-linked bonds to hedge tail risks of “inflation resurgence and policy hawkishness.”

5. For liquidity management, modestly increase cash and highly liquid short-term securities to prepare for future risk-free rate adjustments. Operationally, adopt phased deployment and rolling adjustments, monitoring data and policy developments to avoid large directional bets and path risks.

4. Risk warnings

Market volatility exceeds expectations, economic data surprises, geopolitical conflicts worsen unexpectedly, and historical experience may become invalid.

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